The global meltdown in banking and investment banking is a failure to focus on the correct fundamentals.
Focus was on volume and not the quality of that volume. At the best, the focus was on the top line of the income statement and not the bottom-line profit or loss resulting from the volume.
Any focus on an operating statement is, by definition, short term (no more than 12 months). There was apparently no focus given to the liabilities that could, and did, over a longer term result from the lack of quality of the increased volume.
For example, banks focused on the volume of mortgages that they could generate assuming that any losses generated from a lack of quality would be offset by the investment returns on the dollars generated from that volume. When markets declined, investment returns declined. When residential values securing those mortgages declined, the value of those mortgages as an assets became less than their associated liabilities, resulting in a charge to net worth.
Invest banking and brokerage firms focused on fees generated from sale of securities, many of which were bundled mortgages. The brokers or agents selling these securities are compensated by the volume of the securities sold. No one asked, “What happened if the value of the credit securing these mortgages falls?” No one focused on the long term value of these securities. No one considered whether these securities were suitable to the persons to whom they were offered.
To change focus, the incentive and compensation systems must change. The performance standards for the incentive and compensation must include quality, not solely volume. The metrics should include the bottom line profit or loss over a period time, and not the immediate addition to the top line. And the factors considered must be expanded to include stewardship of the balance sheet, especially the longer term impact on ratio of assets to liabilities and the long term effect on net worth or surplus.
Only when we change the focus of the incentive and compensation systems can we refocus global business on the correct fundaments: The long term impact on net worth or surplus.